THE BEAR'S LAIR A new model for nastiness
By Martin Hutchinson
Since the late 1990s, bears like myself have been forecasting a major economic
downturn in the United States, but wavering as to whether it would be more like
the 1930s, with price deflation and really deep economic decline, or the 1970s,
with unpleasant inflation but shallower economic decline. The urge to forecast
gloom and despondency continues, even intensifies, but we need a new model for
the type of depression we are to enter, as neither the 1930s nor the 1970s now
seems to fit the bill.
The causes of the Great Depression have been analyzed ad infinitum, and there
is still not general agreement as to their relative importance. The major
downward revaluation of asset prices - stocks and to a lesser extent housing
and real estate - that occurred after 1929 certainly played a significant role.
From the Japanese 1990s experience, it would have been likely to lead
to a decade of below-par growth, but not necessarily to a catastrophic
downturn. The lack of a significant downturn after the 1987 crash and the
relative mildness of the downturn after 2000 also suggest that asset price
declines are a contributing but by no means controlling factor.
Other contributors to the Great Depression were the sharp move towards
protectionism epitomized by the 1930 Smoot-Hawley Tariff (although the world of
1930 was already highly protectionist by modern standards), the international
banking crisis sparked by the 1931 collapse of Austria's Creditanstalt and the
extraordinary stupidity of the Herbert Hoover administration in raising the top
rate of income tax from 25% to 63% in early 1932. Other Hoover administration
activities failed to improve matters, but do not seem to have made them much
worse, though Smoot-Hawley and the income tax hike together push Hoover well
beyond the unlucky and well-meaning James Buchanan on the list of America's
worst presidents.
The 1970s stagflation was initially caused by excessive public spending for the
Vietnam war, which created a severe deficit problem, exacerbated by sloppy
monetary policy, particularly around the time of president Richard Nixon's 1972
re-election. The oil and commodities price hikes of 1973 played a supporting
role in throwing the world into stagflation but were largely effects of loose
monetary policy in the US, Britain and Japan rather than independent causal
factors. After a remission caused by president Gerald Ford's conservative
fiscal policy, further monetary and fiscal sloppiness under president Jimmy
Carter brought a recurrence of the problem, which was only solved by the advent
of Paul Volcker to the Federal Reserve chairmanship in 1979.
The sharp eye will immediately note that there is very little commonality
between the causes of the two episodes. There was no surge of protectionism
during the 1970s, nor was there a sharp stock market crash such as had
precipitated matters in 1929 (though stock prices declined in real terms by
three quarters between 1966 and 1982, undoubtedly producing a depressing effect
on the economy). There was a banking crash in 1973 in Britain, a pretty
spectacular one, but nothing like the 1931-33 global cascade of bank failures.
There were no enormous tax increases during the 1970s.
Conversely, US fiscal management during the 1920s had been a paragon of
rectitude under Treasury secretary Andrew Mellon. There had been some excess
money creation in 1927-29, but interest rates remained securely positive in
real terms. Just as most of the Great Depression's causal factors were absent
in the 1970s, so none of the causes of 1970s stagflation were significantly
present in 1929-32.
That suggests that the taxonomy of major downturns probably has more than two
archetypes, and that we should not seek to fit the current episode closely to
either the 1930s or the 1970s but examine it in its own right, expecting a
major downturn if it occurs to be of some third type not closely resembling
either.
This time around, we certainly have had the long-term fiscal and monetary
sloppiness that caused the 1970s stagflation. However, we also have had an
asset price bubble that seen in certain lights looks more severe than in 1929.
We currently have a worldwide outbreak of protectionism similar to that of
1930, although much less extreme, and we have a banking crisis that if things
go wrong may well resemble the rout of 1931-33. With presumptive presidential
candidate Senator Barack Obama proposing increases in taxation on higher
incomes, we may even have the equivalent of Hoover's 1932 tax policies,
although presumably the rise will be less severe than the 38 percentage point
marginal rate increase that Hoover imposed.
The Great Depression and the 1970s represent extreme cases of economic
downturns. The Great Depression had a gigantic economic hole (in the United
States) but no inflation at all, rather the opposite, whereas the 1970s was
primarily about inflation, with the economic downturns being fairly mild and
confined to manufacturing (though if you were in heavy industry in 1979-82 it
wasn't fun.)
Both downturns were generally felt around the world, with the 1930s downturn
being severe pretty well everywhere (probably least severe in Britain although
the 1920s had been pretty unpleasant there) and the 1970s one avoiding the
Middle East (because of their oil revenues) parts of Latin America (Brazil had
an excellent few years until 1980 or so - its problems occurred during the
1980s) and the Asian Tiger emerging markets outside Japan.
Since this time around we have most of the symptoms of the Great Depression and
the 1970s (albeit in lesser degree in the case of 1930s protectionism and tax
rises) we could reasonably expect a downturn that shared the nastier features
of both. It would have more depth than did the 1970s downturns outside
manufacturing, and it be would unlike the 1930s be inflationary. It would also
almost certainly include a major 1930s style asset price decline, although part
of that would be obscured by the 1970s style inflation. For example, the US
house price decline currently under way is likely to be substantially cushioned
by increases in nominal incomes, as households receive pay increases that do
not keep them ahead of inflation but nevertheless hold them within shouting
distance of it.
Internationally, the downturn seems likely to be most severe in countries and
regions where asset price inflation has been most intense. In the developed
world, Japan should more or less escape it, as should South Korea and Germany.
None of them have had house price or stock price booms of any magnitude in the
past few years. At the other end of the scale, Britain (primarily housing) the
US (both housing and the remaining un-deflated stock bubble from the late
1990s) and Spain (housing again) will probably have severe downturns, as may
China (primarily real estate, but also stocks and the banking system in
general.)
If we believe that the downturn is likely to share some of the characteristics
of the 1930s, rather than being simply a repeat of the 1970s, then it is
unlikely that oil producing countries and commodity exporters will escape
problems. Oil prices have been driven up to levels considerably higher in real
terms than the 1970s by demand pull from China and India. If China and to a
lesser extent India suffer severe downturns, then oil demand must drop off
correspondingly and it becomes unlikely that the 1970s pattern of continuing
high oil prices even in a recession will be repeated.
If oil prices drop sharply, the political effect on oil producing countries
will be considerable, and not necessarily pleasant. The Shah of Iran basically
fell because of the 1973 oil price rise. He was already overspending in 1972-3,
supported largely by bank loans, then he spent with total abandon in 1974 as
higher revenues had appeared to make Iran's oil wealth inexhaustible. Needless
to say, he then ran out of money, as the international banking system would not
provide him with sufficient funds to complete the projects he'd initiated in
the bubble year. 1976 and 1977 were thus years of relative austerity in Iran,
much to the fury of the Iranian people who had come to expect a bonanza. It
should thus have been no surprise that revolution occurred in 1979, although
robust US support for the shah might have enabled him to overcome it.
This time around, the overspending oil producers are obvious: Venezuela and
Russia. Venezuela will undoubtedly get into severe difficulty once the oil
price collapses. This is on balance likely to favor US interests (and those of
the Venezuelan people) provided that the crisis can be leveraged to remove Hugo
Chavez from the country's leadership. If he remains, Venezuela will become
another Cuba, with deep repression and a suffering and impoverished populace
but forming no real threat to the United States.
Russia is a much more dangerous story, being both economically and militarily
more powerful. The parallels with Germany of the 1930s are disquieting,
although the move to aggression in an economic downturn would presumably take
the form of an assumption of further authoritarian powers by Vladimir Putin,
rather than his replacement by an even more sinister figure.
However a downturn in the oil price might well cause an aggressive Russia to
intervene militarily in its neighbors, use the weapon of Gazprom's gas
pipelines disruptively against Western Europe and devote 25% of output to the
military, as did the Soviet Union in its most aggressive periods. Should that
happen, Russia would become a considerably more dangerous threat to the world
than al-Qaeda could ever dream of; it is to be hoped that western leaders,
particularly in Europe, recognize the danger early and effectively.
The balance of probability must thus be for a global downturn which combines
the inflation of the 1970s with the severe recession and geopolitical danger of
the 1930s. Not an appealing prospect.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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